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Bold monetary experiments of Raghuram Rajan’s RBI : Volatile living

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My parents couldn't afford a blazer for me: RBI Governor Raghuram Rajan
My parents couldn't afford a blazer for me: RBI Governor Raghuram Rajan

The bold monetary experiment that the Indian and Chinese central banks engaged in this year might one day be hailed as a success. So far, the result has been unprecedented market volatility and little else.

Both central banks targeted interbank rates to control the supply of money, aiming for a more surgical monetary tool than orthodox bank reserves or policy interest rates.

The People’s Bank of China (PBOC) and the Reserve Bank of India (RBI) were worried that sticking with traditional policy rates or bank reserves would have had a greater impact on the overall economy and slowed growth, which they wanted to avoid.

“They shifted to a more interest-rate based system in both cases. Both central banks should be applauded for doing that,” said Frederic Neumann, co-head of economic research at HSBC in Hong Kong.

Both central banks are looking to liberalise their markets, but the PBOC and RBI are adopting a similar policy strategy in very different situations and for different reasons.

China is now using its open market operations almost exclusively to try to rein in a credit binge. Apart from growth concerns, the PBOC feared that raising policy rates or reserve ratios would have added unwelcome fuel to a rally in its currency.

India had similar GDP concerns after growth slumped in recent years. But, unlike China, it urgently needed to shore up its currency, which dropped in August to a record low, and to tame steep inflation.

Economists feel it is too soon to pass judgement on these policies and they are impressed that the two giants tried to move towards market-based pricing in what has been a challenging year for emerging markets.

The experiment is an attempt by both countries to release some of their central grip on the economy and develop deeper roles for markets.

But for middle income countries such as China and India – the top tier of emerging economies but not yet developed like Western nations – there is no boilerplate recipe.

South Korea’s experience in trying to liberalise its financial system and currency in the late 1990s was riddled with policy missteps, bankruptcies and crises.

Until this year, Beijing and New Delhi had countered the classic ‘impossible trinity’ of trying to control capital flows, interest rates and their currencies at the same time through quantitative measures: bank reserve ratios, lending quotas and regulated investments.


India’s volatility has its origins in frequent and impulsive monetary policy swings.

“The volatility in interest rates is certainly negative for economic growth in both markets. It makes planning decisions much harder,” said HSBC’s Neumann.

Unlike China, India has relatively deep short-term funding markets and mature derivatives trade, but interbank rates have moved in a wide 9 percentage point range this year.

The Sensex rallied to record highs after new RBI Governor Raghuram Rajan took steps to stabilise the rupee.

However, business investment has suffered, economic growth has weakened further and markets have been left to second-guess the central bank’s priorities: the currency, growth or inflation.

Rajan, an ex-IMF economist, may have picked the wrong time to try and deepen India’s interbank markets, namely while he was fire-fighting a currency crisis.

His attempts to create tiered overnight rates and wean India’s banks off volatile short-term funding have left markets confused about which benchmark to follow and which way policy is headed.

The two central banks may have swerved too far to embrace a new policy focus, economists say.

“Perhaps in the transition phase central banks have to use both tools, the old and the new market-based tools, concurrently and redouble efforts at creating deeper money and capital markets” said Neumann.

“But you can’t go back. That would maybe stop the natural evolution in its tracks.”

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